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March 21, 2014

Increased Salaries ≠ Higher Ticket Prices

(editor's note: This article first appeared on Ruben's Rants)
Fans of sports teams often complain when players sign big contracts, because the common fan can no longer afford to buy tickets. The reasoning goes that the team will need to raise prices to be able to pay the high salaries their stars command. You hear a variation of the following: “Damn greedy players! If they were paid, say only $1 million per year instead of $10 million, they could still afford the finer things in life, and at least the average working man could afford to take his family out to the odd ballgame.” Well, let me tell you, THIS IS A HUGE FALLACY!
Before I explain why, let me use a very simple fictional example:

Your company makes and sells widgets. They cost $100 each to manufacture. Get a piece of paper and answer the following questions under these different scenarios:

Scenario 1

You have a whole warehouse full of these. You are the owner, and have no additional expenses and no employees: You would like to make a 10% profit.

Question 1: How much should you sell these widgets for?

Scenario 2

You don’t have any already made, but you can make them as needed for $100 each. However, you require employees to sell them, and on average it takes them one hour to complete each sale. You have a customer who is willing to pay up to $200 for as many of these as you can produce. Your employees get paid $10/hour

Question 2: How much should you sell these widgets for now?

Scenario 3

Same as #2, but now your employees unionize and demand $25 per hour.

Question 3: How much should you sell the widgets for now?
Make sure you write your answers down before continuing. No cheating!

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Answers:

# 1: $110 is not the right answer. Well, it might be but probably not. The answer is the maximum amount that your customers are willing to pay. It does not matter whether or not it’s above $100. If the most you can sell them for is $5, even though you are losing money, you are ‘only’ losing $95 on each one you made, rather than $100. If customers are willing to pay you $500, then that’s what you should charge. The point is that it is independent of the actual cost*. Also, the fact that you’d like a 10% profit is very nice. I’d like for there to be clean water available to every child on the planet. That ain’t happening anytime soon either and is just as (ir)relevant.

#2: $200. The customer will not pay $201 for it, and why would you only charge $199 if you can maximize your profit? By the way, you will make a $90 profit on each unit sold. I hope you got the answer to this one correct, since it was right in the question.

#3: $200. See explanation for #2. Note that now you are only making a $ 75 profit on each unit.

There are two takeaways from the above: (1) You can only charge however much a customer is willing to pay for a product, regardless of your costs. (2) The fact that your labor rates increased, only impacted the profit you made, but had no bearing on the selling price. In other words, see (1).

Yay, I’ve just covered a basic business lesson that every student in junior high should know, but you’re a football/baseball/basketball/UFC/female mud wrestling/horse racing/hockey/lacrosse/whatever fan and what the hell does this have to do with your home team anyways? The owner just said in a press release that he had no choice but to raise ticket prices to be able to continue to put a quality product on the field, because of the rising salaries. You know what? Your team’s owner just BULLSHITTED you. There is one reason, and one reason only why ticket prices increased. Because YOU are willing to pay the higher price. You might not be happy about it, but you will do it. (Or maybe you really can’t afford to. Ok, I believe you. But you know what? Somebody is willing to pay that, and that’s all the team cares about.). I don’t wonder why teams don’t lower ticket prices to allow the average working person to afford tickets, what I do wonder is why teams that constantly sell out don’t raise ticket prices? They should raise them until they stop selling out, then they know they are a little too high. It’s called the law of supply and demand and it’s the most basic business fundamental.

Why do owners treat all of us like we’re six years old and cry “Whoa me – I hate to do this but I have to”, instead of “I invested my capital into this venture and have had a lot of personal risk at stake, so now I’m going to maximize my profit, suckers!”. It may not go over as well, but at least it’s more honest.

* Ok, economics majors, before you point out the flaw in my argument, this is an obvious oversimplification. For a product with demand, the huge markup only applies if you have a unique product that nobody else can feasibly make (i.e., high barriers to entry in the industry) or you can only sustain it for a short period of time. Otherwise, as soon as others see you are charging $500 for something that costs $100 to make, they are going to compete against you and only charge $495. This will force you to reduce your price to $490 and so on, until an equilibrium is reached at $110 or $120 or whatever profit margin is reasonable for the financial risk that the company is taking. i.e, at some point you lower the price to an amount that your competition may match but won’t be willing to beat. For products with no discernible demand the $5 analogy does apply – getting pennies on the dollar is better than bubkus